The key policy challenges facing countries in Central, Eastern, and Southeastern Europe remain broadly unchanged, among them supporting domestic demand, addressing financial crisis legacies, rebuilding buffers against external shocks, and improving the business environment. Country-specific priorities depend on how far along they are in the postcrisis adjustment and their exposure to external risks.

*/ The boundaries, colors, denominations, and any other information shown on the maps do not imply, on the part of the International Monetary Fund, any judgment on the legal status of any territory or any endorsement or acceptance of such boundaries. In this report, statistical data on Crimea and the City of Sevastopol are included as part of the data for the Russian Federation.

Reconciling Fiscal Consolidation and Growth

November 13, 2015

Executive Summary

Much of the Central, Eastern, and Southeastern Europe (CESEE) is growing at a healthy pace, while Russia and other CIS economies are facing significant economic challenges. The region as a whole is expected to return to positive growth next year. Overall, activity in the region is set to contract by 0.6 percent in 2015 and expand by 1.3 percent in 2016. This is little changed from the spring 2015 projections, but the risks have shifted to the downside:

Central and Eastern Europe (CEE), Turkey, and most of the Southeastern European (SEE) countries are expected to maintain solid, largely domestic-demand-driven growth in 2015–16. There are also some external tailwinds, such as lower oil prices and improved euro-area growth prospects. Furthermore, several CESEE European Union (EU) member states benefited from a temporary boost to investment from a sharp increase in utilization of EU Structural and Cohesion Funds (SCFs). In contrast, growth has softened in the Baltics due to weaker demand from the CIS.

The economies of Russia, Ukraine, and other CIS countries will contract this year, with some stabilization expected in 2016. Russia continues to adjust to low oil prices and Western sanctions, but is expected to remain in recession in 2016. Ukraine is projected to return to positive growth next year, despite multiple challenges related to ambitious reforms, significant macroeconomic adjustment, and economic dislocations in the eastern part of the country.

And the balance of risks has shifted to the downside. New risks to trade and capital flows stemming from a possible further slowdown in major emerging markets (notably, in China) as well as the ongoing refugee crisis in Europe are the main additions to long-standing risks.

The key policy challenges are broadly similar from those discussed in the Spring 2015 Regional Economic Issues report. Supporting domestic demand, addressing crisis legacies, rebuilding buffers against external shocks, and improving the business environment to boost investment and long-term growth remain important. Country-specific priorities depend on how far along these economies are in the postcrisis adjustment and their exposure to external risks.

Where the recovery is well advanced, the policy priorities need to increasingly shift toward the medium term, including rebuilding fiscal buffers and continuing with reforms to improve the business environment and address structural weaknesses. This is not to deny that there is still a lot of uncertainty about the strength of global recovery that, domestically, inflation is still too low in many CESEE economies, and that the key crisis legacies—high nonperforming loans (NPLs) and debt overhangs–still need to be addressed in some countries (notably, in SEE).

For economies that are in recession, the key challenge is to steer the adjustment to terms-of-trade and other shocks with a view to supporting weak internal demand and reducing high inflation.

Countries vulnerable to external shocks—such as those with large external financing needs, weak fiscal positions, or high dependence on commodity exports—need to be prepared to deal with market pressures by using exchange rate flexibility as a shock absorber alongside macro-prudential policies to contain the buildup of financial sector risks and gradually rebuild foreign exchange reserves if they are below prudent levels.

Large fiscal challenges remain in CESEE, despite progress with consolidating the fiscal stance and improving the quality of budgets in recent years. Can CESEE countries reconcile fiscal consolidation with growth? The analysis presented in this Regional Economic Issues report offers some insights:

Most CESEE economies entered the 2008–09 global financial crisis with growth-unfriendly budgetary structures relative to their peers. On the spending side, budgets were characterized by high public consumption and large unproductive transfers. On the revenue side, they were characterized by a disproportionate reliance on labor taxes, notably social security contributions. Structures reflected a mixture of legacy issues from the economic transition of the 1990s, an aging population burdening social security systems, and an orientation based on Advanced Europe, which sustains similar budgetary structures but with support from much higher per capita incomes.

Budgets have generally improved since the global financial crisis, when severe pressure on many CESEE budgets forced fiscal adjustment. On the revenue side, many countries managed to shift the tax burden from taxes harmful to growth—such as the corporate income tax (CIT)—to more neutral forms as taxation—such as the Value-Added Tax (VAT). On the spending side, countries with access to EU SCFs often managed to avoid large cuts in public investment. Large fiscal savings came instead from reforming entitlement programs and reducing public consumption.

Fiscal consolidation in CESEE has not yet run its course, with sizable adjustment needs remaining, especially in SEE. To safeguard or improve the quality of budgets during consolidation, the focus should be on reducing unproductive transfers and further reforming entitlement programs, including public pension systems. Restructuring public employment may also be called for, especially where the public sector wage bill is high, either because of excessive employment levels or disproportionately high public sector wages. On the revenue side, policymakers should focus on achieving a sizable part of the adjustment through indirect taxes, and consider the introduction or strengthening of carbon and property taxes.

For countries that do not have urgent fiscal consolidation needs, fiscal reform is still called for to enhance the quality of their budgets, including by shifting taxation toward indirect taxes, and increasing the efficiency of health and infrastructure expenditures.

Approved by

Poul Thomsen

Prepared by a staff team consisting of Ernesto Crivelli, Plamen Iossifov, Jiri Podpiera, Faezeh Raei, Haonan Qu, Yan Sun and Jiae Yoo, with input from country teams and research assistance from Tiberiu Scutaru and Xuan Tu. The team was led by Anna Ilyina and Johannes Wiegand, under the general guidance of Jörg Decressin. Administrative support was provided by Gilda Ordonez-Baric.